Transcript of Question & Answer Session The Labour Market and Monetary Policy

Well, my two questions refer to Ben Bernanke's presidential address to the American Economic Association on the 4th of January, 2020. It was in San Diego when I was lucky enough to be there sitting in the second row and the speech was called New Tools for Monetary Policy. Ben Bernanke says that the neutral interest rate is the interest rate consistent with full employment and inflation at the target in the long run. Most current estimates of the nominal neutral rate for the United States are in the range between 2 and 3% and the median projection of FOMC participants, even in the most recent summary of economic projections, is 2.5%. The problem, Bernanke says is that the Fed needs to cut, not needs to cut rates in an average downturn by about 5.5%. Bernanke says that a nominal neutral rate of 5.5% would require lifting the inflation target by 3%, from 2% now, all the way up to 5%.

On the other hand, he says quantitative easing and forward guidance can provide an additional 3% increase in policy space to offset the effects of the lower bound on short term rates. And this suggests that at a nominal neutral rate of 2.5%, quantitative easing will be necessary in almost all future business cycles and will have to provide at least three fifths of all the monetary easing in the future slumps.

So the first question Governor, is do you think that quantitative easing will be necessary in almost all future business cycles and will it have to do the heavy lifting to provide the stimulus in future economic slumps?

Thank you, that's a great question. It's quite probable that bond purchases will have a role to play in managing the cycle in the future. But I do think there are limits here. There's a limit to how much of the existing stock of assets that it makes sense for a central bank to buy. The effects of these asset purchases are cumulative. Each time we go through a cycle, you'll own more and more of assets, unless the assets that we buy in one cycle are sold or mature before the next one starts. So there are limits here. A central bank can't keep on buying up existing stock of assets and I don't think it makes sense to do that. We do need other options to manage the next cycle. I think the first of these options and we shouldn't forget this, is conventional interest rate policy and this is one reason why we're keen to get the inflation rate back to 2 to 3%.

If we can get it back to 2 to 3% sustainably, then interest rates will be able to be normalised. And that means when the next downturn comes, we'll be able to inject monetary stimulus through the standard way of lowering the cash rate. I think it's important that we get some fire power back eventually, so that we can respond to the next downturn because we know there will be another downturn and we will want a monetary policy response.

The second option that needs to be on the table is fiscal policy. We've seen over the past year and a bit, fiscal policy played an incredibly constructive role during the pandemic. And it's quite likely, I think, that if interest rates are going to be at low levels for many years, that fiscal policy is going to need to play a bigger role in the future. If monetary policy is constrained because there is a limit to how many assets that you can ultimately buy. And the ability to cut interest rates is limited because rates are already low, then fiscal policy is going to have to play a bigger role and I know the Treasury are thinking about mechanisms and approaches to make that effective because we all know there are challenges here in using fiscal policy in a countercyclical sense.

So quantitative easing will have an ongoing role but I think it would be unwise to rely on that as the main instrument of macroeconomic management.

Okay. My second question, Raghuram Rajan, in setting up the monetary policy target for the Reserve Bank of India selected a higher inflation target of 4% and Olivier Blanchard has also suggested a higher inflation target than the level of 2%. A higher inflation target would solve some of the problem caused by the lower long-term nominal neutral rate. Now, we just had a surprise international agreement as a result of a lot of work by the OECD in increasing the minimum level of company tax. So do you think there's ever a prospect of an international agreement between Central Banks to increase the inflation target from the current level of around about 2%?

Well, there are no such discussions going on at the moment. Our current discussions are about how we can achieve the targets we have, and I was on another conference call last night, discussing that set of issues. So, we're really focused at the moment on achieving the targets that we have, which we've struggled to do over the past decade, rather than to set even higher targets to achieve. There's a general agreement that what we should be striving for is a low, positive rate of inflation that doesn't materially distort decision-making in the economy. The widespread consensus is that that number is somewhere between 2 and 3% and if you have higher rates of inflation, say 4 or 5%, then you will start to see distortions in the economy.

So a low and stable rate of inflation is the best way of dealing with the situation. I think the other general consideration that we talk about in our meetings is that if you change the target once, that opens up the possibility of further changes in the future and there's some risk that you could unanchor inflation and wage expectations. I think that's not an argument for never making a change, but it does mean that the hurdle for making a change to the inflation target is quite high. There needs to be a compelling argument that we'd get better outcomes for the society by targeting an inflation rate of 3 or 4 than the current rate to make the change. And my view and the view of my colleagues is the compelling arguments aren't there yet, not to say they couldn't emerge in the future but they're not there yet.

Thanks very much for the presentation, Governor Lowe. We have questions coming in thick and fast from the audience and I'd like to start with a couple from high school students … And the question is with the cash rate at a record low of 0.1%, is there any possibility that Australia may consider a negative cash rate? And if so, what implications will this have on our economy?

The answer to that is that we're not considering a negative interest rate. I think the time for that consideration has passed. The economy is doing better and it would be a curious decision given the strength of the economy now for us to move into negative territory. So that's the cyclical situation. Even before the recovery was strong, we had a very low appetite for negative interest rates. The evidence, at least my reading of the evidence, is that negative interest rates have not been particularly successful. And you might've noticed that during the pandemic no country that was in positive territory went to negative and the central banks that were in negative territory, didn't go further negative. There's a reason for that and that is it doesn't seem particularly effective.

Negative rates start to cause problems in the banking system, banking profitability can decline and banks may not be as prepared to make loans. And we also saw in some countries that people responded to negative interest rates by saving more. You put $100 in the bank today and the bank tells you, you're only going to get back $98 at the end of the year. That might encourage people to save more. Lower interest rates are supposed to encourage people to save less and spend more, so the effects can be perverse. We don't need to consider it now because the economy is improving, but even when the economy was in a hole we weren't considering it either. Thank you.

Another question from an economics student, Dr Lowe. What implications have been observed from the other unconventional measures that the RBA has implemented such as the TFF (Term Funding Facility) and how do you see the conduct of these policies evolving in the future?

The TFF has been really important in keeping the funding costs down for the banking system. We've lent almost $200 billion to the banks at an interest rate of 0.1 of 1% for three years and that's allowed the banks to make low interest rate loans to people and it's also meant the banks have had a lot of liquidity … to support businesses and customers. So it's been really important. The Term Funding Facility now has closed to new drawers but those loans are out there for three years. So, they're going to keep funding costs down in the economy for the next three years.

I would hope that going forward, we don't need to have a repeat of that. I don't see any signs of stress in the financial system that would require it and I hope that we wouldn't need to do that again in the future. But it's a tool that we do have if we saw stresses in the financial system, which at the moment there are no signs of. And you asked about the other unconventional policies. The bond purchases have been really important in lowering the whole structure of the yield curve in Australia. That helps keep interest rates down for borrowers, lower interest rates give people cash flow. So businesses and households have more money to spend and the lower interest rates have also pushed up asset prices and thereby supporting balance sheets. I think through those channels what used to be called unconventional policies have actually supported jobs in Australia and supported the recovery we've experienced.

I'm sure you're spurring on many high school economics essays as we speak. Great answer. I'm going to move now … you mentioned you weren't inclined to move the inflation target but he asks given that you won't expect inflation to take hold until 2024 or to be sustainably within the target until 2024, do you think there is any need to let inflation run above the midpoint for a time, to anchor inflation expectations and maximise the probability of it being sustained within the target?

That's a good question. My immediate challenge is to get inflation to the 2 to 3% target, but I don't think that's going to happen until 2024. So we haven't formally considered the issue of whether there's benefit in having inflation run above the target for a number of years. That issue we'll have to confront at some point but it's not one that we've turned our minds to yet. My main focus is actually getting the inflation rate back to the 2 to 3% range and the main way for us to do that is to get unemployment lower, get underemployment lower. So that firms, who are reticent to pay bigger wage rises, have to actually pay bigger wage rises. Wages start increasing at 3-plus per cent and eventually that will translate into higher inflation. So that's our focus and it's going to remain the focus for the next couple of years.

I've got a question now from James, he's wondering, why do you think there is a disconnect between the RBA and the private sector's expectations on the timing of the next cash rate rise? Is it due to differences in wage growth expectations, differences in modelling or is the private sector just overly optimistic about the future path of the pandemic?

Well, I can only speak for our views, and so perhaps I can repeat our view again for you, and then other people can judge why the private sector has a different view. Our fundamental assessment is that these factors that have kept wages growth low, while they're going to gradually dissipate, that's going to take a long time. The last time the wages growth in Australia was above 3% was a decade ago. It took a decade to go from 3 to 1.5%. There were powerful and deep structural factors at work, there was the supply response I've talked about as well; the business psychology. I don't see those factors going away quickly. They were there for a decade. They're fundamental, they're global. I don't see them turning around quickly and because we don't see them turning around quickly, we think the grind higher in wages will be slow.

And if wages growth is still running with a 2 in front of it, it's going to be very difficult for us to deliver an inflation rate starting with 2 or 2.5. So that process is going to take time to work through. There are two possibilities why the market has a different view. One is that they think the closure of the borders will lead to a hothouse environment and wages will pick up more quickly. So that's possible but I think it's a more plausible scenario that eventually over time, the borders open again and some of the hothouse pressure points in the labour market dissipate. The other at least conceptual possibility is that the markets don't believe our reaction function.

I sometimes read commentary that we'll raise interest rates to choke off housing prices and with housing prices rising quickly, the Reserve Bank will raise interest rates to choke that off but that's a misunderstanding of our reaction function. We won't be raising interest rates to choke off housing price increases. If borrowing is unsustainable, then we'd be talking with APRA about prudential tools but we're not going to use monetary policy to deal with rising housing prices. That would be the wrong thing to do and I don't think it would work. Some people think we'll do that. So if I can disabuse anyone who has that view, that there's any probability of that being in our reaction function, then thank you for giving me the opportunity to do that.

Well, thank you. I think that was pretty crystal clear. We've had a couple of questions … you mentioned assumptions around border re-openings there, Dr Lowe, what is the RBA's assumption about when the international border opens?

Well, in the last set of forecasts, we were proceeding on the basis that it opened around the end of this year. So we are about to undertake a new forecasting round. We'll have to make another assessment. I think in terms of wage pressures, what's really important is not the generalised opening of the borders but allowing workers to come into the country where there are skills that are in short supply, or we can't find the workers, because it's these pressure points that can build that we get large wage increases in those pressure points and they spill over to the rest of the community. So I know from many of my meetings with businesses that they're struggling to find the workers that they want and I note that government ministers have spoken about this issue as well and it's one of the priority areas that they're focusing on.

So if that doesn't happen, if the borders remain completely closed and we can't get workers into the country that are needed for firms to expand and invest, I think we will see more wages growth. Some people might think that's good. On the other hand, we'll see less investment, less confident businesses, lower output and ultimately a lower capital stock and a less dynamic economy. So it's really a first order issue and we're proceeding on the basis that over the next six months or so, a way will be found gradually to allow the workers who are most needed to get into the country. If that doesn't happen then the outlook looks quite different.

I've got a question from Michael who is responding to some of your comments on the impact of immigration on labour markets. He says your comments could be interpreted as a criticism of the use of overseas workers. However, international trade in anything including labour suggests it should make both countries better off in the absence of externalities. Can you address concerns that you might be criticising the use of overseas workers?

Well, I'm certainly not criticising the use of overseas workers. I'm trying to apply an analytical lens to it and say, "Well, what effects did this have?" I said in my prepared remarks, allowing workers with skills in short supply into the country allows businesses to expand and invest, increase the productive capital base of Australia. Imagine during the resource boom, if we hadn't been able to draw on the global labour market, we wouldn't have been able to have all that investment, which is fundamental to Australia's prosperity. So having overseas workers come into the country is incredibly beneficial. But applying this analytical lens, I think it does take the pressure off some of the hotspots in the local labour market.

If we hadn't had half a million people in the country who were on these temporary visas, then I think we would have had more hotspots in the labour market, which would have temporarily given us higher wage increases. But ultimately it would've given us lower levels of output and a lower capital stock. So I'm certainly not criticising this at all. I'm trying to understand the implications of it for wages, output and investment. And I look forward to the day that the borders are open again and businesses can once again benefit from tapping into a global labour market.

Fantastic, thank you, also very clear. A question from Zach at Monash University. He takes the point that the stock of bond purchases is the best measure for support for the economy. But he notes keeping purchases at 5 billion per week would mean a higher stock and thus more support. So why did the RBA choose to have a smaller stock of bond purchases when inflation is still so far below target?

Right when we started these bond purchases, we set out a framework that we were going to use to analyse our future decisions. As I said before, that framework was based on the effectiveness of them, what other central banks are doing and the progress we'd made towards our goals. Back in February, as I said in my prepared remarks, we thought the unemployment rate today would be 6.5%. It's 5.1 and job vacancies are at a record level. So we thought, consistent with the framework that we've articulated, which the third and most important consideration was progress towards our goals, we've made progress. And if we didn't decide to scale back when we've made such substantial progress, I don't know when we would decide to scale back.

So it's a modest scaling back and it's reflecting the progress that we've made. We're going to keep buying these bonds until we make more material progress. And really what we want to see, the key thing we want to see, is evidence that the stronger growth in jobs and output is translating into stronger increases in wages and inflation. So we're going to keep going until that happens but as we get closer to those objectives, I hope you can understand that it makes sense to scale back a bit. And then by the time we get to those objectives, we will finish this. So it's really a response to the stronger economy.

Thank you. I think we've probably got time for one more question. I am seeing a lot of questions coming through on property prices. I know you've been extremely clear that you won't be using monetary policy settings to deal with high and rising prices but a number are coming in from economics teachers in particular, so I think this might be part of the syllabus as well. What more do you think the government or others should be doing if we're not going to be using monetary policy to manage the increase in property prices?

I'm generally not in the business of telling others what they should be doing. I'm in the business of putting an analytical prism over what's happening and trying to understand it. Lower interest rates are pushing up housing prices. It's not just in Australia but everywhere around the world. We need these low interest rates to get people into jobs, to get wages moving, to get inflation back to target. So from my perspective, back onto the monetary policy reaction function, if we were to use interest rates to slow housing prices, that would be effective for a while, at least. But it would mean fewer people had jobs, wage increases would be lower and inflation will be lower. It doesn't seem a particularly good trade off to me and it's not one that our mandate would allow us to make anyhow.

The question that you asked, which is good, what else can be done? I'm not saying this should be done but the structural reasons we have higher housing prices in Australia relate to, it's all about supply and demand. A lot of us want to live in these fantastic global cities, on the coast, on large blocks of land and we've chronically under-invested in transport. So I believe this is a first-year economic question: if you live in a country where everyone wants to live in, squeezed into, fantastic global cities on the coast, on large blocks of land, don't have much transport, we haven't invested much in transport and the government gives you incentives to do that, would that country have high or low housing prices?

I think most students would answer that, high. So that's why we've got structurally higher housing prices in the country. If the society wants to do something about that, it has to address those issues, those issues about where we live, how we live, how we invest in transport and how we tax land. I'll leave it to others to comment on whether we should move on some of those things. My view is we should but I'm not going to go into any specifics.

Well, thank you very much. I think there were certainly some policy solutions knotted to there at the very least. Thank you so much for your time, Governor Lowe, it's certainly a very interesting time for macroeconomic policy and I think this type of speech and your willingness to respond to so many different questions is incredibly important for shedding light on the Reserve Bank's direction and thinking, so thank you again on behalf of the Economic Society.

Thank you very much, and I look forward to visiting Brisbane soon.